With interest rates at historically low levels, it seems like there's no place for them to go but up. But rising interest rates would decrease the value of existing bonds. The 4% interest they already yield on the market will bring lower prices if newly issued bonds yield 5% or 6%.

Likewise, falling bond prices mean that bond funds lose value. Not all bond-type funds are heading south, though. Bank-loan funds offer a hedge against rising interest rates: They can pay higher yields and fund values can go up, too. "Bank-loan funds probably make more sense than any other fixed-income investment out there now," says Lou Stanasolovich, a certified financial planner and president and CEO of Legend Financial Advisors in Pittsburgh.

As you might suspect, these funds buy bank loans. "They buy secured, floating-rate loans that banks have made to corporations," explains Stanasolovich. "The loans have interest rates that are reset every 60 to 90 days. Therefore, if interest rates rise, the payments due on these loans will move higher and the loans will increase in value."

According to mutual fund research company Morningstar Inc., the bank-loan fund category has had positive returns every year for more than a decade. In 2003, the category's average total return was more than 10%, bringing its 10 year average up to 5.5%. As of this writing, the category's average yield was 3.7%. "These funds make sense if you want an investment that produces income, if you have a moderate risk tolerance, and if you're seeking a fixed-income investment that is less susceptible to interest rate increases," says Ben Utley, a certified financial planner in Eugene, Oregon.

But bank-loan funds do have risks. "If you want protection against rising interest rates along with higher yields than you'll earn in a money market fund, you must give up something. With bank-loan funds, you have a slight risk of capital loss," says Utley.

The loans in these funds' portfolios may have been made to corporations in less-than-stellar financial condition. Although the loans are secured, they may default, and in some cases the collateral backing of these loans is insufficient to repay the debt. In other cases repayments are delayed. Defaults, therefore, can drag down the returns of bank-loan funds.

In 2001 and 2002, when the economy staggered, bank-loan funds gained a mere 1.58% and 0.63% as a category. Some lost money in those years. But 2004 and 2005 shape up as a "perfect storm" for bank-loan funds. If interest rates rise, as expected, yields will move up.

If you want to invest in bank-loan funds, you should be aware that they have an average expense ratio of around 1.5%, the highest of any bond-fund category. According to Morningstar, bond funds generally tend to charge around 1%. If you hunt for bank loan funds with a relatively low expense ratio, you'll increase your chances of receiving a higher yield.

Other costs to investors include possible sales charges. "There are few no-load funds in this category. An exception is the Fidelity Floating Rate High Income fund (FFRHX)," says Morningstar Senior Analyst Scott Berry.

If you invest in a bank-loan fund through a broker, you'll pay a sales charge, or load. "Among load funds," says Berry, "Eaton Vance Prime Rate Reserves (EVPRX) has a solid record. Both Eaton Vance and Fidelity have strong research capabilities, which may help them avoid buying bad loans."

You also should be aware that liquidity might be limited. There is typically a fixed time period, once each quarter, when you can withdraw money from these funds.

Another option may be available to investors who work with a financial planner. "We pool clients' money so we can get into Columbia Floating Rate Z (XLFZX), where the minimum investment is $250,000," says Stanasolovich. "The yield in this fund is extremely high [4.7% as of this writing]. Once you're in the fund, there's quarterly liquidity, with no minimum for withdrawals."


                                                 1-yr.         3-yr.
Fund Name                             Ticker     Return        Return

Columbia Floating Rate Advantage A    XSFRX      21.71         7.97
ING Senior Income Fund A              XSIAX       8.82         6.14
Columbia Floating Rate A              XLFAX      15.85         6.03
Van Kampen Senior Loan Fund B         XPRTX      18.59         4.89
Oppenheimer Senior Floating Rate A    XOSAX      10.83         4.81
Merrill Lynch Senior Floating Rate    XMPFX      14.50         4.46
Eaton Vance Floating Rate Hi Inc Adv  EAFHX       8.46         4.30
SunAmerica Senior Floating Rate B     XNASX      10.31         4.07
Morgan Stanley Prune Income Trust     XPITX      15.76         3.99
Fidelity Advisor Float Rate Hi Inc A  FFRAX       5.55         3.87

                                      5-yr.                    Initial
Fund Name                             Return     Phone         Purchase

Columbia Floating Rate Advantage A     NA        800-345-6611  $1,000
ING Senior Income Fund A               NA        800-992-0180   1,000
Columbia Floating Rate A               NA        800-345-6611   1,000
Van Kampen Senior Loan Fund B         3.30       800-421-5666   1,000
Oppenheimer Senior Floating Rate A     NA        800-525-1048   1,000
Merrill Lynch Senior Floating Rate    4.25       800-654-6837   1,000
Eaton Vance Floating Rate Hi Inc Adv   NA        800-225-6265   1,000
SunAmerica Senior Floating Rate B     4.54       800-858-8850   5,000
Morgan Stanley Prune Income Trust     4.32       800-869-6397   1,000
Fidelity Advisor Float Rate Hi Inc A   NA        800-522-7297   2,500


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